This Hot IPO is Headed for Trouble

On a recent trip to Boulder, CO, I stood outside a Tesla Motors (Nasdaq: TSLA) showroom ogling its sports cars with lust in my heart. A few weeks later, when a Tesla roadster whooshed silently past me on a New York City street, my heart skipped a beat. Tesla makes the kinds of cars that auto enthusiasts lust after. Then again, I have a short attention span. Minutes later, a Porsche 911 zoomed past me with its inimitable throaty growl, and my lust was re-directed.

My fickle tastes highlight a real problem for Tesla. The company is aiming to crack two auto market niches, though success looks like a long shot in each. The car faces heady competition in a crowded sports car field, and the electric car market is also about to get crowded.

Investor message boards are filled with Tesla's vitriolic detractors and even more rabid supporters. So I won't weigh in as to whether Tesla builds the world's coolest cars or simply overpriced go-karts. The truth lies somewhere in between.

Others suggest that Tesla isn't a car company, so much as a technology development company. Hogwash. This is a car company, plain and simple, and investors need to focus on the economics of the auto industry. In this business, the odds of success are so overwhelming that it's impossible to see how Tesla will ever reach positive cash flow.

Volume is everything
Tesla wisely decided to first focus on a halo car, the Tesla Roadster. The company established its cred with the "money-is-no-object" crowd, as nearly 500 consumers paid six figure sums to be the first in the neighborhood to own an electric sports car. In the auto world, it's far easier to move down market than up market. Hyundai is trying to do so after many years of effort. Volkswagen tried with the Phaeton and failed miserably.

The down-market move: Tesla's niche market roadster will soon be joined by a more mass market sedan known as the "Model S." And when it arrives in showrooms, possibly in 2012, it will represent clear advances over the Roadster in terms of mileage range and broad market appeal. But by 2012, the Model S may already be late to the game, as cars from Ford (NYSE: F), GM, Mitsubishi, Nissan, Mini, Toyota (NYSE: TM) and others peddle impressive electric cars as well. The key distinction is that those auto makers will be able to spread development costs among more cars and will handily undercut Tesla on price.

Going instead after the Volvo/BMW crowd instead isn't necessarily a bad thing, but it's simply unclear how Tesla can compete by building cars in the thousands while its rivals build cars by the tens or hundreds of thousands. The auto industry is all about scale, and no auto maker has ever been able to sell cars for less than $100,000 in volumes below 10,000 and been able to thrive. Just ask Saab or Hummer about that.

Tesla's supporters argue that its cars will be similar to luxury sedan rivals in terms of performance, durability and comfort, while also providing cutting edge electric vehicle technology. The company believes that power storage and management will be the game-changer. Tesla has been working on its core propulsion system for more than five years and expects to squeeze an increasing number of miles out of every watt that its power pack generates. That is also the goal of every other auto maker and battery technology in the world as well. And it's simply unclear how or why Tesla will end up with the best mouse trap.

Do the math
Once the Model S production lines are at full volume, Tesla believes it will generate 25% gross margins. To get there, the company has embarked on a range of cost reduction initiatives, when compared to the Roadster, which appears to have carried miniscule or negative gross margins. As a point of reference, Ford hasn't even cracked 15% gross margins since 2004.

What has happened since then? The auto industry has become awash in far too much capacity, and auto makers have had to compete much more aggressively on price. Even BMW hasn't generated 25% gross margins in a number of years. Porsche's gross margins exceed 40%, but that's with an average selling price on its cars in excess of $75,000. The Tesla Model S is expected to be priced closer to $50,000. And Porsche makes 75,000 to 100,000 cars a year. Tesla aims to ramp up annual production to just 20,000 units by 2013, so it will have to spread unit costs over a much smaller base.

Tesla also thinks that operating margins can exceed 10%, as operating expenses will be well below industry norms. To get there, the company anticipates fewer repairs and very limited ad spending. But the company's Roadster model has been dogged by a series of defects, and even if the new Model S proves quite reliable, that's a boast that almost any major manufacturer can claim these days. And word-of-mouth marketing approach may have worked for the Roadster model, but the Model S sedan will be competing with similar offerings from other manufacturers -- all of which anticipate hefty marketing budgets.

More prosaically, you have to wonder about total demand for electric cars. Many recent reviews for the Nissan leaf and the Mitsubishi i-Mev focus on "range anxiety," the notion of the fears of running out of power and being stranded. That's led reviewers to assume that electric cars will be great second cars, used for commuting to work and other limited runs. But those second cars, the ones you see parked at railroad parking lots, are usually inexpensive economy cars. The Tesla Model S will be priced far too high for that.

Action to Take --> Be wary of bullish Wall Street reports on Tesla. The company is expected to keep raising more money after this summer's IPO, as it is unlikely to reach break-even for at least three or four years, according to optimistic Wall Street earnings models. I have my doubts that the company will ever move into the black.

If I'm right, then the end game for Tesla will be to sell itself to another auto maker that can better capitalize on industry economics. And that price would likely be far lower than the company's current $2 billion market value.

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